Tax Hikes Coming No Matter Who Wins White House

Regardless of who wins the White House this November, the new health-care law will raise taxes on high-income Americans next year—and that could have implications for stocks and other assets.

Starting Jan. 1, there will be an additional 3.8 percent tax on investment income—including capital gains, dividends and rental income. It will apply to married couples with adjusted gross income of $250,000 or more and for individuals above $200,000.

There will also be a 0.9 percent tax next year on all salaries and wages earned above those same threshold amounts.

The new taxes, part of the 2010 health care law, are expected to help fund Medicare.

The tax hikes mean that the current dividend and capital gains tax rates of 15 percent will rise to at least to 18.8 percent next year for the wealthiest tax payers.

If Democrats win the White House and Senate, they are expected to push for a 20 percent capital gains and dividend tax rate, while Republican presidential hopeful Mitt Romney favors no change.

Should the U.S. hit the “fiscal cliff”and Congress lets the Bush tax cuts expire on Dec. 31, the highest income bracket would revert back to 39.6 percent. So with an additional 3.8 percent investment income tax, dividends could be taxed at 43.4 percent. (Read More: Taxing the Credibility of Politicians)

“I think people understand their dividends are going to be taxed differently, but many of them don’t understand the magnitude of that jump,” said Leo Grohowski, CIO of BNY Mellon Wealth Management.

Bill Stone, chief investment strategist at PNC Wealth Management, said he’s been recommending clients take more capital gains this year than they normally would but says many are not yet focused on the issue, possibly because so much is unclear about tax policy ahead of the election. (Read More: Bull Market Is 'Halfway Done')

“We’ve recommended, all things being equal, considering taking a little more capital gains than normal. It’s pretty much a given that the capital gains for our high net worth clients goes up just because of the health care,” he said. “They could roll it back, but it seems a low likelihood.”

Stone also said the current low-yield environment means that dividend stocks will remain attractive, even with higher tax rates.

“We decided this time, that it doesn’t make a whole lot of sense moving away from dividend paying stocks,” he said.

Dan Clifton, head of policy research at Strategas, writes that the increase from 15 percent to 23.8 percent, if the Democrats win and do adopt a 20 percent rate, would be a 63 percent increase in the capital gains and dividend tax rate for higher earners.

“A higher capital gains tax lowers the after-tax rate of return on equities, and all else being equal, should lower equity values,” he wrote in a note Tuesday.

Clifton said that the two times capital gains taxes were increased, without tax reform, stocks moved lower. While three of the four times, capital gains taxes were cut resulted in higher stock prices six months later. The exception was 1981, during the recession.

“The last tax increase was part of the comprehensive tax reform in 1986 which slashed tax rates on income and corporate taxes,” he wrote. “The S&P initially sold off on the inclusion of the higher capital gains tax rates but a 28 percent income and 33 percent corporate tax rate overwhelmed the negative impact of higher capital gains.

Congress reduced the capital gains tax by 25 percent and the dividend tax by 61 percent in 2003. Clifton said the capital gains tax cut “overpowered” the dividend tax cut, and dividend stocks ended up underperforming after that tax cut. (Read More: Tax Cuts for the Rich Don’t Spur Growth)

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There was also a correlation between small caps outperformance and the lowered capital gains tax rate, and Clifton expects small cap stocks to underperform if capital gains taxes are increased.

“Our review of the 2003 dividend tax debate found that high-yielding dividend stocks did not outperform during the 2003 tax cut, largely because of the capital gains tax change at the same time,” Clifton wrote.

Clifton also says the 2003 tax change had a big impact on dividend paying behavior, because prior to that the S&P 500 had seen a 25-year decline in dividend paying companies which he blamed on “discriminatory tax treatment of dividends.” For example, following the 1997 capital gains tax cut, dividends were taxed at 40 percent while capital gains were at just 20 percent.

Clifton says it will be important to watch whether the two taxes are treated differently in the tax debate that will come right after the election.

Strategas analysts built portfolios to reflect what would happen in the event of a Democratic or Republican sweep. Cilfton said the Democrat portfolio was designed to reflect higher taxes on income, capital gains and dividends. It included municipal bonds, because they would become more attractive on a tax basis. Also, rising dividend tax rates would make REITs attractive compared to other dividend payers, and they also included companies with a history of raising dividends for more than 40 years. (See: Equities Will be Stronger Under Romney Tax Policy—Scaramucci)

“We believe dividend and capital gains tax rates will be higher but also equalized at the same rate. Our justification for dividends would change if Congress reverted back to pre-2003 policy and dividends were taxed at twice the rate of capital gains,” though that is unlikely, he wrote.

Clifton also noted that Strategas believes the fiscal cliff will result in a fiscal drag of 1.1 percent. "Should the Bush tax cuts for the wealthy on income, capital gains, and dividends not get extend, we would expect an additional 0.5 percent fiscal drag,” he noted. The fiscal drag would increase the risk of recession, which favors dividend stocks.

Grohowski said he sees a 50 percent chance the economy hits the “cliff” at the end of the year, which would mean an end to Bush tax cuts and the automatic spending cuts that take place as part of the debt ceiling compromise.

Grohowski said that makes already pricey dividend stocks like utilities, REITs and MLPs less attractive.

“I think the market right now is discounting exactly the team we have on the field, Democratic president, Republican House, Democratic Senate. That’s what the market is telling us,” he said.

“What if there’s a surprise? A surprise would mean a Romney victory. I’d move up slightly our yearend forecast for the S&P but not dramatically,” he said. Some of these issues that are a cloud overhanging the market would be there either way.

“The policy uncertainty, you have to be thinking about that, and adjusting for that,” he said. “Valuation looks good, but not outstandingly. Valuations are going up, and earnings are going down.”